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Analysis: Boom and bust and boom again

The latest quarterly European Venture Capital Report, by Dow Jones VentureOne and Ernst & Young, reveals that web 2.0 is driving venture capital (VC) investment in the IT sector, which has seen the most significant upturn of any industry in the first quarter of 2007.

In total, £376.8 million was invested in 133 technology deals,
representing £20.6m more in capital and 11 more deals compared
with the first quarter of 2006.

This growth has occurred within a climate of flattened VC investment in
European companies, with the £760m invested in the first quarter
of 2007 reflecting investment in the same period last year.

"The emerging interest in web 2.0 technology, which is mostly focused in
the information services segment, appears to be fuelling this growth in
European technology investments," says Jessica Canning, director of
global research for VentureOne.

This follows Ernst & Young's research from the end of 2006, which
predicted that VC investment for the year would top £16 billion,
bringing it to its highest level since 2002, when the global figure was
around £25.8bn. Ernst &Young's VC advisory group global director
picked out web 2.0 along with clean, biotechnologies as key areas of
interest for the new wave of investment.

That today's major VC investment area is web 2.0 is hardly surprising,
because VC necessarily mirrors what is happening in the market.

May alone saw teen community Piczo announce a global expansion plan, and
the return of Boo.com as a travel network, although the latter received
little VC involvement.

BMW (for its new 1 series) and iVillage are among brands that have
recently enhanced their interactive, UGC features (see Revolution, May
2007), while review site Trusted Places received funding from Howzat
Media, the investment company set up by Cheaplights.co.uk founders, in
February.

But, as VCs take a renewed interest in digital companies, concerns are
rife that their role in the last crash - where over-evaluation of
businesses prompted the collapse - could be repeated.

Past lessons

In the late 1990s, a huge amount of money was invested by VCs in
internet ideas with little or no proven business model.

"The numbers looked amazing - this was the big difference between
internet and classic business models," Tom Teichman, chairman of dotcom
incubator NewMedia Spark, recalls. Investors saw opportunities to invest
in companies that would go public within a year or two. But the
technology was not in place and the market was not ready.

By 2003, many firms were forced to write off companies they had funded
just a few years earlier, and many funds were found 'underwater' (that
is. with a market value lower than the invested value).

Thinking again?

Will the latest internet investment revival, fuelled by deals such as
eBay's acquisition of Skype, News Corps' MySpace deal and the runaway
success of Google, be built on the valuable lessons of the past?

Julie Meyer the chief executive of Ariadne Capital, Skype's strategic
adviser in 2004, and more recently focused on comms applications such as
Spin Vox and Monitise, new-media applications and gaming firms.

She says: "In 1999, I saw a lot of investors funding companies to expand
them internationally, taking on fixed costs without any recurring
revenue streams.

"What Skype demonstrated is that there is a new way of segmenting your
customer base - the 'go-to-market' strategies are sounder and less
cost-rich than before."

Meyer describes a difference between 'me too' VCs and those that are
truly differentiated from the herd. She identifies further segmentation
within the early stage, namely the "early early" and "late early"
investors.

Late early investors look for companies that have already derisked
somewhat.

The early early investors, according to Meyer, are not taking risks with
entrepreneurs.

In fact, they have probably already worked with them. The risk in this
instance is market-based, but Meyer prefers this type of investment, for
its creative opportunities.

She describes how progression in technology is strengthening marketing
opportunities: "What technology is doing - and Google's whole essence is
this, - is making marketing more precise, so marketing is coming to the
fore, and technology is enabling it to become measurable.

"The past 20 years of the tech industry have been the triumph of great
marketing companies over tech firms, but now it is more profound as
marketing pounds and sterling can be targeted and held accountable."

Different investors

Importantly, she adds, many of the key VC players are different. Few of
the investors active in the dotcom boom and crash are still here.

Another fundamental difference is that it takes less money to get a
new-media start-up off the ground. "With broadband and open-source
tools, and generally more infrastructure built into the web,
entrepreneurial spend on technology has come way down," says Meyer.

Teichman,refers to the 1998 launch of lastminute.com: "They had to build
a huge amount of new software, the costs on servers, databases and so on
were unpredictable. And then they didn't work as we wished, and service
was slow," he says.

Teichman points to success stories such as MySpace, YouTube and Amazon.
Why are they doing so well?

"It's down to huge economies of scale," he explains. "They can crank up
the traffic with few overheads."

In the early days, lack of broadband technology was a major issue. At
this point, with increased broadband penetration rates in many
countries, especially the UK and US, the market is there, willing and
able.

Richard Eyre, chairman of the Internet Advertising Bureau, said that all
it takes to start up online these days are "the negligible assets - just
an idea, software and viral appeal".

But VCs are generally being shrewder now.

Simon Murdoch is chief executive of the recently launched,
language-sharing destination, Friendsabroad.com, and also the
entrepreneur behind Book Pages, which was eventually sold to Amazon.

The early days weren't easy: "We failed to raise VC money. I hadn't
built much of a team by 1997 and competitors were already raising
funds," he says.

Murdoch eventually raised £1m from investor angels, and sold to
Amazon within three months.

Murdoch adds that VC boom or not, it's still not as easy to raise money
as in the peak of 2000. "Entrepreneurs used to get money after
one-minute pitches. VCs now look for experienced entrepreneurs who also
have great ideas."

A great idea alone doesn't, however, guarantee success. Teichman
identifies a new kind of financial risk.

"Ideas today have to grab virally and quickly. Lots of people have
internet access today, and while you can set up a fantastic, creative
site, it doesn't mean they will look.

"The challenge now is to create a simple, elegant site, with no
irrelevant content, to ensure people come back. Today's consumer is
aware of being sold to, and doesn't like it."

NewMedia Spark's recent investments include digital advertising
business, Unanimis, and notonthehighstreet.com, the latter run by former
Publicis and Conde Nast figures. Teichman says new ventures need
seasoned business people, not just visionaries, who have the flexibility
to change direction. He describes investment now as: "Less about
chucking huge amounts of capital in, more about thinking sharp.

"When, from 2001-2006, the industry was starved of capital, we realised
we had to be smarter about software, marketing, staff and be willing to
take ownership rather than huge salaries. Ease up on salary and take an
upstart risk," he advises.

Downturn 2.0

So will there be another crash? "If there is a real setback today, more
professional than private investors will be damaged," says Teichman.

"VCs are not handling direct public money so the public is cushioned.
The Nasdaq is half what is was in 2000, so while there may be an
adjustment, I can't imagine anything like the initial bust happening
again."

The Skype founder Niklas Zennstrom has said that, while the current boom
is built on more solid foundations - with widespread internet use and
soaring online sales - he cannot rule out the possibility of a downturn
at some point.

This view is echoed by Meyer.

She says: "More people are using PCs, the internet, and have broadband,
so whether there will be a crash is one point, but whether the pace of
living more of our lives online decreases is another.

"We will continue to live more of our lives online, managing our
relationships, communications, finances and so on, even non-techie
people do that these days, but most certainly there will be another
downturn again. It's probably a year away," she says. "However, some
sort of terrorist attack, God forbid, could precipitate that coming
sooner."

The dotcom climate is currently buzzing with new investment
opportunities.

In contrast with the first boom days, when US firms were the big
winners, the European market is looking healthy, with exits achieving
high evaluations.

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